Systems and methods for increasing participation of liquidity providers on crossing system

ABSTRACT

In one aspect, the invention comprises a system for enabling a crossing system operator to calculate a rebate payment to a second participant for executing the block order of a first participant based on at least one of: (a) a difference between a benchmark price and an execution price of the block order; (b) total volume of block execution; and (c) an amount that decays exponentially with the time between the first participant&#39;s order and the order&#39;s execution by a liquidity provider.

CROSS REFERENCE TO RELATED APPLICATIONS

This application claims priority to U.S. Provisional Patent ApplicationNo. 60/808,103, filed May 23, 2006. The entire contents of thatprovisional application are incorporated herein by reference.

BACKGROUND AND SUMMARY

Crossing systems designed to enable the execution of large block ordersencounter the difficulty of focusing liquidity at the same point inprice and time. Various solutions to this problem have been deployed.Various electronic markets offer scheduled crosses at specific points inthe day. For example, Pipeline and LiquidNet attempt to attract crossingblocks at any time of the day by delivering invitations to trade topotential counter-parties and offering mechanisms to facilitateconvergence in price. These methods succeed only to the extent thatlarge buyers and sellers have latent liquidity ready to be routed to themarket and not previously committed to another strategy. As a result,fill rates on orders committed to crossing systems are low, typically1-5% depending on the stock's liquidity.

To bridge the gap in time and strategies, liquidity providers willing tocommit capital can take on a position on the crossing system and wind itdown at a different time or using a different strategy. However, theprice of the block trade on the crossing system then becomes a principaldriver of profitability for the liquidity provider, creating a directconflict of interest with the institution that had committed its blockorder to the crossing system. The liquidity provider has an incentive togame the execution price on the crossing system by buying the blocklower and retaining the difference as part of its trading profit.

Crossing systems have devised various mechanisms to prevent potentialdamage to their customers' interests. LiquidNet simply precludes theparticipation of liquidity providers. Pipeline protects theinstitutional order's interests via a large minimum quantity, hiding theside, using orange and yellow indicators to give an informational edgeto resident aggressive orders, fuzzying the time when these indicatorsare turned on or off, and enabling an order's limit price and time inforce to remain unknown. POSIT randomizes the execution time.

Of these systems, only POSIT enables liquidity providers to participateprofitably, but it falls short in protecting the institutional order, asliquidity providers can probe the crossing system with small quantitiesto discover an imbalance in large buy/sell interest and later tradeaccordingly on the continuous market. Pipeline's rules, in contrast,have proven themselves to be effective at protecting the resident order,with the result that liquidity providers acting on a regularcommission-based pricing model have not found it profitable to trade onthe system, even when their commissions are reduced all the way to zero.

Standard rebate models such as those used by ECNs provide a negativecommission, typically limited to $0.002 per share. These payments aretoo small to cover adverse information costs associated with large blockorders. To the extent that they could be raised to a level sufficient toattract liquidity providers to larger blocks, one would still be facedwith a strong incentive to find ways to game the crossing system'spricing mechanism. The solutions described above would be only animperfect remedy, likely to diminish but not eliminate the damage causedby predators looking to game the execution price.

What is needed is a mechanism for providing rebate payments that enablesliquidity providers to participate and raise crossing ratesdramatically, while neutralizing the incentive to game the executionprice on the block crossing system.

Embodiments of the subject invention relate to software-based systemsand methods for encouraging capital providers to facilitate trades withgood execution quality on a block trading system.

Embodiments of the system subject of the present invention overcome thelimitations of known liquidity rebate payment systems by calculatingrebate payments in a manner that neutralizes (preferably, exactlyneutralizes) the incentive to game the execution price on a blockcrossing system.

The combination of higher crossing rates and execution quality providesa strong value proposition to the user, thereby enabling the crossingsystem that uses this rebate mechanism to strengthen customer loyaltyand sustain a premium price that can be used to offset the cost of therebate mechanism.

In one aspect, the invention comprises a system for enabling a crossingsystem operator to calculate a rebate payment to a second participantfor executing the block order of a first participant based on at leastone of: (a) a difference between a benchmark price and an executionprice of the block order; (b) total volume of block execution; and (c)an amount that decays exponentially with the time between the firstparticipant's order and the order's execution by a liquidity provider.

In another aspect, the invention comprises a system for enabling acrossing system operator to calculate a rebate payment to a firstparticipant upon execution by a second participant of an order placed bythe first participant, based on at least one of: (a) a differencebetween a benchmark price and an execution price of the block order; (b)total volume of the block execution; and (c) an amount that decaysexponentially with a time between the first participant's order and theorder's execution by a liquidity provider.

BRIEF DESCRIPTION OF THE DRAWINGS

FIGS. 1 and 2 depict steps performed by an embodiment.

DETAILED DESCRIPTION OF CERTAIN EMBODIMENTS

Embodiments of the invention rely on adopting a benchmark price againstwhich the price of a trade on the crossing system can be measured. Thiscan be, for example, the volume-weighted average price (VWAP) of alltape-reported prints in a window covering five times the block quantitybefore and after the print, truncated to the market open and close timesif needed.

Alternatively, the benchmark price can be the daily VWAP (well-known inthe art), or available VWAP (from the time of the trade to the end ofday), or in a time window such as 10 minutes before and after the trade.Other benchmark prices will be apparent to those skilled in the art Inan embodiment aimed at deterring benchmark gaming, the system randomlyassigns any one of several benchmark prices to each trade.

A crossing network operator preferably offers an execution qualityrebate that equals the difference, for each execution, between theblock's value at the actual execution price and its value at thebenchmark price:

Rebate=(Block Price−Benchmark Price)

Absent this rebate, the liquidity provider's profitability is determinedby the difference between the actual execution price and the price atwhich the position will be sold. So the net profitability PL of theliquidity provider's strategy for a block bought on the crossing systemand sold elsewhere, including the execution quality rebate, is:

$\begin{matrix}{{PL} = {\left( {{{Sell}\mspace{14mu} {Price}} - {{Block}\mspace{14mu} {Price}}} \right) +}} \\{\left( {{{Block}\mspace{14mu} {Price}} - {{Benchmark}\mspace{14mu} {Price}}} \right)} \\{= {{{Sell}\mspace{14mu} {Price}} - {{Benchmark}\mspace{14mu} {Price}}}}\end{matrix}$

The net effect of the rebate payments, therefore, is to replace thetrade price with the benchmark price for the liquidity provider, whilemaintaining the benefit of an in-line execution price at the time of thetrade for the institutional user.

The value proposition to the liquidity provider is to exploit the optionof executing or not executing an order in the crossing system dependingupon their ability to unwind on the market at better-than-benchmarkprices. Strategies to exploit such an option are described below.

There are at least two sources of profits for the liquidity provider.(1) If a stock's price has just come down sharply, the current marketprice is below the trailing average price and therefore is relativelylikely to end up below the Benchmark price, So if the price drop isrobust, there could be an opportunity to sell the block on the crossingnetwork and buy it back at below-benchmark prices. (2) if a stock istrading in a range, one can adopt a range trading strategy on thecontinuous market, buying at the low end of the range and selling nearthe high, and use the crossing system to “stop” the position should thestock break out of its range.

Even without knowing the side or even having the certainty that theorder exists on the crossing system, the possibility of a stop sufficesto provide a statistical edge over a standard range-trading strategy.Indeed, if one believes that markets are efficient at balancing theprofitability of range trading strategies against the risk of loss inthe event of a breakout, the partial stop advantage suffices to breakthis balance in favor of the liquidity provider. The end result iseither better-than-benchmark executions of the institutional order, ornothing, insofar as the crossing system is concerned.

For the institutional order, greater fill rates will occur afterfavorable price movements (buying after the price has dropped), astrategy that is generally beneficial to their interests to the extentthat institutions typically have more to do than they commit at any onetime, and therefore tend to tilt the balance in favor of mean reversionwhen market moves run into their trading interest. The cost of providingthe rebates must be passed on to the user, but to the extent that thecrossing system's fill rates are substantially higher than without thepresent invention, users will find it to their interest to accept ahigher commission in order to get a quick fill on a large order, andindirectly benefit from the skill of sophisticated liquidity providersat unwinding large positions with very little market impact. Therefore,all parties are benefited by the present invention.

In an embodiment aimed at limiting the cost to the crossing system, inthe event that the liquidity provider were to finance excessivelygenerous fills on the system and recover the losses through the rebatemechanism at the end of the month, the rebate is reduced by a penaltyterm that discourages prints that are too generously priced compared tothe price during the time period after the trade, long enough to see 5times the block quantity on the tape, hereinafter called “Post TradePrice.” The theoretical P&L of a trade may be defined as (again takingthe example of a block bought on the crossing system):

Theoretical PL=(Post Trade Price−Block Price)

Theoretical PL Penalty=F(Theoretical PL Per Share), where (in $ pershare)

F(x)=0 for x>=−0.03

-   -   −x/0.15 for −0.15<x<0.03    -   1 for x<−0.15

Rebate=(Block Price−Benchmark Price)−Theoretical PL Penalty.

In an alternate embodiment, the loss is expressed in relative termsrather than in cents, by considering the price difference in basispoints, as is known in the art.

In an embodiment aimed to discourage the practice of market timing orpeg gaming, the system further measures the range of prices printed tothe tape in an interval before and after the trade, where each intervalis the greater of 10 minutes or the time needed to see as many sharesprinted to the tape as the block quantity, and determines whether theblock trade is in the lower third of both ranges. If that is the case,the price difference between the block price and the average price inthe intervals before and after is assessed as a penalty in the rebate:

Hump Penalty=Block Price−(Before Price+After Price)/2.

Combining this with the above mentioned penalty, one arrives at:

Rebate=(Block Price−Benchmark Price)−Theoretical PL Penalty−HumpPenalty.

In another embodiment, the rebate is incremented by a conventional pershare volume rebate to encourage further activity by liquidityproviders.

In another embodiment, the rebate is incremented by an immediacy rebatethat starts at a given per share amount and decays exponentially withthe time elapsed since the order arrived in the crossing system, wherethe decay timescale is the time it takes for an amount of shares equalto one block quantity to print to the tape based on the stock's averagedaily volume. The initial per share amount is preferably setindependently for each stock to an amount that reflects the riskassociated with holding a block position in the stock, such as thestandard deviation of the stock (in cents) over the above timescale.Alternatively, the initial per share amount of the immediacy rebate isdetermined empirically to stimulate the desired level of activity byliquidity providers, and published to participating liquidity providers.If a liquidity provider is involved in multiple block trades in the samesymbol in the course of the day, the immediacy rebate is preferablycounted only on the first block:

Rebate=(Block Price−Benchmark Price)−Theoretical PL Penalty−HumpPenalty+Volume Rebate+Immediacy Rebate.

In an embodiment aimed at eliminating the incentive for adverse markettiming system-wide, the system awards the execution quality rebate toall crossing system participants whose overall volume surpasses aspecified level.

In a further embodiment, the system awards the execution quality rebateto all crossing system participants. In this embodiment, the executionseffectively take place at the benchmark price, but are reported at themarket price at the time of the execution and effectively re-pricedlater through the rebate mechanism to avoid the technical difficultiesfor locking-in trades in an order management system at a price to bedetermined in the future.

Steps performed by an embodiment of the invention are depicted in FIGS.1 and 2.

It will be appreciated that the present invention has been described byway of example only, and that improvements and modifications may be madeto the invention without departing from the scope or spirit thereof.

1. A system for enabling a crossing system operator to calculate arebate payment to a second participant for executing the block order ofa first participant based on at least one of: (a) a difference between abenchmark price and an execution price of said block order; (b) totalvolume of block execution; and (c) an amount that decays exponentiallywith a time between said first participant's order and said order'sexecution by a liquidity provider.
 2. A system for enabling a crossingsystem operator to calculate a rebate payment to a first participantupon execution by a second participant of an order placed by said firstparticipant, based on at least one of: (a) a difference between abenchmark price and an execution price of said block order; (b) totalvolume of said block execution; and (c) an amount that decaysexponentially with a time between said first participant's order andsaid order's execution by a liquidity provider.